Suppliers know more about their production costs than their customers. However, with Should Costing, purchasers of complex supplier products can avoid inadequate conditions.
Defining fair prices in procurement is often difficult for suppliers and buyers. The customer’s urge to procure as cheaply as possible and the supplier’s desire to achieve the highest possible margins are simply mutually exclusive goals. The supplier has an advantage in this respect, since he has a head start in terms of information about his production costs and expenses. It is precisely this advantage that can lead to excessive purchase prices. In the long term, there is a risk that improvements that would help both sides will not even be addressed.
It is therefore the task of procurement to reduce the knowledge gap with the supplier in order to determine the appropriate price for a product on the basis of additional information and to raise cooperation with the supplier to a new level.
But what can procurement professionals do? Attempts to break down the price structure and production costs of suppliers themselves often failed in the past because such an analysis is immensely time-consuming. The factors that influence the final price of a product are too diverse.
But new times bring new opportunities: data analysis is easier today than ever before. Until around the turn of the millennium, only large corporations with high technical and financial resources could implement the complicated computational models to gain advantages over their suppliers. In the age of Big Data, things are different.
Should Costing reveals significant savings potentials
Should Costing enables customers to perform detailed analyses of their suppliers’ cost structure and save costs in the double-digit percentage range by comparing real and requested prices. The amount of savings that can be achieved depends heavily on the initial situation and the components purchased and – according to experience from INVERTO projects – averages 14 percent. The method is not suitable for every company and every sector. Sectors with few suppliers and few interchangeable components or monopolistic supplier structures, such as those found in some areas of the automotive industry, can benefit particularly.
In Should Costing, buyers first evaluate the individual cost factors of a product in isolation. These include, for example, raw materials and individual components. In addition, labor hours, production facilities, assembly of the individual components, and transportation are also included. Of course, the purchaser must also take into account the lead times and quantities that the supplier produces.
In order to be able to assess these production-specific cost components, in-depth know-how and insight into the production conditions are necessary – knowledge that is often not available in the customer’s own company. Wage costs, for example, differ depending on the production location. The production process also plays a role: How modern and efficient are the machines? What safety and environmental standards must the factory meet?
For standard components, cost databases available on the market can help. On the other hand, companies can obtain production-specific information for non-standard components by working closely with the supplier. If the supplier is not willing to provide information, asking a competitor may help. In addition, there are external experts who can provide a realistic assessment based on years of expertise.
Once you have broken down all the costs, the next step is to calculate and evaluate the supplier’s margin. This should of course be fair – but what does fair mean in this context? An analysis of the supplier’s current margin situation and a comparison with suitable peer groups, such as companies from the same industry and of a similar size, can help with the evaluation.
Should costing offers opportunities for better cooperation
If the analysis shows that the supplier is not offering appropriate conditions, this should be discussed together. Confrontation and pressure should not be the means of choice here; instead, it is important to clarify why a supplier is demanding an excessive price. Should costing should not be seen as a means of exerting pressure, but as an opportunity for both sides to work together more efficiently.
5 steps to a successful application of Should Costing
The more information is available about the product to be procured, the better you can calculate the manufacturing costs. If there is insufficient information available, you should use experts for this purpose.
- Assumptions made and cost items must be well-founded, up-to-date and explainable, otherwise you will discredit your entire analysis and lose credibility with suppliers.
- Don’t neglect overhead distribution analysis. While the cost pool is quite small in absolute terms, it often offers the greatest potential in percentage terms.
- Do not send your own calculations right at the beginning of the discussions, otherwise you will give away the argumentation. Instead, go through cost block by cost block together with the supplier and exchange information bit by bit.
- Have your own specialists participate in the discussion with the supplier, who can discuss the cost items and the assumptions behind them at a technical level.
- Simple aspects such as the procurement of raw materials are only the first step, which is made possible with a should-costing analysis. If the relationship with the supplier is trusting enough, the use of new and more efficient production processes or machines can also be discussed to further reduce costs for both sides.
Used correctly, Should Costing can improve the entire supply chain. The customer enjoys savings, and the supplier becomes more competitive. In the end, the complex analyses pay off for both parties. However, Should Costing is not a tool that can be tackled quickly and completed in one go. It is important to stay tuned: Material costs change constantly, new production processes are developed, new companies enter the market. If you don’t want to let your suppliers’ knowledge lead grow again, you have to maintain your own know-how about cost structures.